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Is Shake Shack, Inc. Stock Too Hot To Handle?

The burger chain was considered overvalued by many after its IPO, but shares have only moved higher.

Shake Shack, Inc. (NYSE:SHAK) is barely three months old as a publicly traded company and already the stock is worth nearly triple its IPO price. After more than doubling on its first day of trading, the stock soared again earlier this month, climbing 20% in two days on virtually no news.

The gains may have been caused by a short squeeze, as bearish investors bought the stock in an attempt to cover their ill-fated bets against it. At the end of March, 34% of shares had been sold short: an indication of how many investors have been skeptical of the stock's valuation.

With the stock at a new high and the company about to report first-quarter earnings, now may be a good time to reevaluate the Shake Shack investing thesis.

Extra Shack sauceAt a price-to-sales ratio of 6 and an earnings multiple in the triple digits, it's easy to see why many think the stock price is too frothy. Shake Shack made a splash in the public markets as the brainchild of renowned restaurateur Danny Meyer. As a result, it carries an outsized reputation for a chain with just 63 stores as of the end of 2014. About half of those are licensed while the other half are company-owned.

Due to the buzz generated by the original Shake Shack in New York, the company has been able to expand in an unorthodox manner, licensing locations in the Middle East and targeting high-traffic real estate for company-operated locations in cities such as Miami, Washington, DC, and Las Vegas.

Source: Shake Shack website

Compared to most restaurant chains, sales at the average Shake Shack unit are huge, coming in at about $4.6 million. McDonald's, on the other hand, which is one of the top-performing restaurants in that category, brought in just $2.5 million in revenue per restaurant last year.

Shake Shack's restaurant-level operating margin is also strong at 24%, meaning each company-owned establishment generates more than $1 million in profit to cover corporate overhead costs. Overall earnings are still thin, but should improve as a larger store base brings down the percentage of revenue spent on SG&A expenses and other corporate costs.

So if the individual restaurants are overwhelmingly successful, the two key questions for investors seem to be whether Shake Shack can expand fast enough to justify the current valuation, and if future openings will bring in the same kind of operating profit that current ones have.

Management has said it aims to open about 10 new company-owned locations per year, growing the company-owned store base by about 30% this year. Unfortunately, the newer stores will not bring in the same level of revenue as the current store base, because Manhattan-based stores bring in a much higher level of revenue and new store openings will come from outside the core Manhattan market.

Still, in 2014, average weekly sales per store fell only modestly, from $95,000 to $88,000, indicating that sales at new stores are still strong, if not as high as the initial base.

However, the company's expansion strategy, which has seen it target the highest-profile locations in new cities, may lead to brand saturation or cannibalization quicker than other fast-food chains. Unlike McDonald'sor Chipotle Mexican Grill, a perception exists that a visit to Shake Shack' is an "event" for its customers rather than a routine stop for a tasty meal. That may explain why sales in Manhattan locations are so high -- many of those visitors are tourists, taking advantage of a visit to NYC to sample the fare at the hottest burger chain.

As Shake Shack expands, the company will need to rely increasingly on regular customers, who will allow it to support a denser store base. So far, this hasn't proven problematic for Shake Shack, as comparable sales are growing, but it remains a risk to keep an eye on as it tries to build out new markets.

California dreamin'Earlier this week, Shake Shack announced it would open its first location in California, setting up shop in LA's West Hollywood neighborhood next year. For a burger chain like Shake Shack, opening in Southern California may be the equivalent of returning to the ancestral homeland. More than anyplace else, California is the birthplace of fast food. It's where McDonald's and many other well-known chains got their start, and it's the home of what many consider to be the original better burger chain, In 'N' Out Burger.

Entering California may be Shake Shack's biggest and most important test yet. If the company can deliver similar results in that highly competitive market, I'd expect more good things from the company. In California and elsewhere, new store performance will be the best indicator of future success for investors to follow.

At its current valuation, Shake Shack stock seems due for a breather, but the long-term story is still intact. The company has targeted opening 450 restaurants domestically. Even at a conservative estimate of $3 million in revenue per restaurant, that would yield $1.35 billion in sales -- and that doesn't include licensing revenue.

At a reasonable profit margin of 7%-8%, that would put net income at $100 million, plus profit from overseas. Using a conservative earnings valuation, that would make the company worth at least $2 billion, if not significantly more. Though today's market value at around $800 million may seem steep, if demand for the company's product persists, that number will only move higher in time.

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Fool since 2011. I write about consumer goods, the big picture, and whatever else piques my interest. Follow me on Twitter to see my latest articles, and for commentary on hot topics in retail and the broad market.
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